This is part one of a three-part series on what does and doesn’t belong in a written LLC operating agreement.
Most people know that when individuals decide to conduct business through a limited liability company (LLC), they should have a written operating agreement. (If you are an LLC owner and didn’t know that, now you know!) A lot of confusion remains, however, about what sorts of terms the operating agreement should cover. As with everything, there are always exceptions, but here are some general rules of thumb to follow when preparing a written operating agreement:
Terms that usually belong:
Who owns the LLC? LLC owners are usually called “members”. A properly drafted operating agreement will list who the members of the LLC are and their “membership interest”, i.e. how much of the LLC each member owns. Membership interests can be expressed in units (which in some ways are analogous to shares of stock in a corporation) or simply by a percentage. In most cases I prefer using units.
What are the members contributing to the company in exchange for their membership interests? Sometimes company founders don’t contribute anything up front to the business, but that is rare. It’s far more common that each LLC member will be expected to contribute something to get the LLC going. Almost every business needs money to get started, so cash is a common example. Sometimes members will contribute equipment or other physical items to the business. Sometimes a member is expect to contribute services or “sweat equity”. Regardless of what exactly is contributed, I recommend that the member’s capital contribution be recorded in a specific, measurable way in the LLC operating agreement.
Who manages the LLC? Some LLCs are managed by their members. In member-managed LLCs, management decisions are typically made by each member voting their percentage interest in the LLC. In other words, if one person owns 25% of the company, she gets 25% of the voting power. Another (in my view usually preferable) structure is to have management of the LLC independent of membership. A person could be an LLC manager without necessarily being a member, and vice-versa. This is particularly suitable for companies who may seek outside investment or want each manager to have an equal vote regardless of whether they are a member or their membership percentage.
Who makes which decisions? This may seem like the same question as who manages the LLC, but it’s not. A good written operating agreement will specify certain types of decisions that require the approval of the members (usually “big-picture” decisions), approval of the managers (usually “day-to-day” decisions), or even those that can be made unilaterally by a manager or officer of the company.
Under what circumstances can a member transfer her LLC interest? LLCs arose out of partnership law, and most closely held LLCs are owned by a set of partners. In business, we typically like to choose who our partners are. For that reason, most LLC operating agreements will impose certain restrictions on the ability of members to transfer their membership interests. You may be fine being in business with your partner, but not fine being in business with her spouse, kids, neighbor, or whoever she can get to give her a few dollars for her LLC ownership share. Thoughtful provisions on the circumstances under which membership interests can be transferred are a necessary part of any operating agreement.
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